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India Unexpectedly Raises Interest Rate

To battle inflation near double digits, Reserve Bank of India raises repurchase rate by 25 bps; may be first in a series of substantial increases.

India’s central bank unexpectedly raised its key interest rate, signaling it’s ready to implement the most sweeping changes in its 78-year history to fight the fastest consumer-price gains in Asia.

Governor Raghuram Rajan boosted the repurchase rate to 8 percent from 7.75 percent, the Reserve Bank of India (RBI) said today. Only three of 45 analysts in a Bloomberg News survey predicted the move, with the rest expecting no change. It came five days after Finance Minister Palaniappan Chidambaram offered a reminder that the central bank has a duty to help growth.

“The gravest risk to the value of the rupee is from CPI [consumer price index] inflation, which remains elevated close to double digits,” Rajan said in a statement. “It’s only by bringing down inflation to a low and stable level that monetary policy can contribute to reviving consumption and investment in a sustainable way.”

Rajan follows Brazil’s central bank in raising the policy rate this month as the risk of capital flight weakens emerging-market currencies from the Turkish lira to South Africa’s rand. Further tightening isn’t anticipated in the near term if consumer-price inflation slows from about 10 percent now to 8 percent by March 2015, India’s central bank said today.

“There is no cooling off in inflation, and we expect it to remain sticky,” said Sonal Varma, an economist at Nomura Holdings Inc. in Mumbai, who correctly predicted today’s move. “As price pressures still remain elevated, and given the RBI’s move towards CPI inflation targeting, we think the bias will be towards higher interest rates going forward.”

The rupee rose 0.9 percent, to 62.5150 per dollar, the biggest single-day gain in more than two months, at the close in Mumbai. The S&P BSE Sensex index fell 0.1 percent. The yield on the 10-year government bond fell to 8.75 percent, from 8.77 percent yesterday. The rupee has declined about 14 percent in the past year, adding to price pressures by raising the cost of imports such as crude oil.

Turkey’s central bank called an emergency meeting to halt its currency slump while China is seeking to avert a trust-product default. The Federal Reserve begins a two-day meeting today as economists forecast a further cut to its monthly bond purchases.

An RBI panel last week recommended making inflation the “predominant objective” of monetary policy for the first time. The panel suggested reducing consumer-price inflation to 8 percent within one year and 6 percent by 2016, at which point it would formally adopt a 4 percent target with a band of plus or minus two percentage points.

‘Volcker-esque’ Approach

Consumer-price inflation will exceed 9 percent in the three months ending March 31, and range between 7.5 percent and 8.5 percent in the same period next year, the RBI said in a separate review today. An increase in the policy rate “will set the economy securely on the recommended disinflationary path,” the central bank said in the statement.

Bringing down consumer inflation to 4 percent may require a “Volcker-esque” approach to monetary policy, Robert Prior-Wandesforde, a Singapore-based economist at Credit Suisse Group AG, said in a note. Paul Volcker was the Fed’s chairman from 1979 to 1987 and pushed interest rates up to 20 percent to tame U.S. inflation that had persisted for a decade.

“Although Rajan (and others) may well be right that such an approach would not have long-term implications for growth, there would certainly be a short-term trade-off,” Prior-Wandesforde wrote. “The latter is likely to worry the politicians, who may well be somewhat peeved that Rajan appears to have adopted at least part of the new policy regime presumably before full discussions have taken place.”

Chidambaram called the inflation target “ambitious” in an interview last week and said the RBI must retain the objective to support growth even as it battles inflation. The panel also suggested that the government cut the fiscal deficit to 3 percent of gross domestic product by March 2017, a target Chidambaram shares.

If inflation slows, Asia’s third-biggest economy can grow between 5 percent and 6 percent in the next fiscal year, ending March 2015, according to the statement. Gross domestic product will expand “a little below” 5 percent in the year through March 31, it said.

Inflation in India

Price gains in India averaged about 10 percent in 2013; they threaten to erode consumer demand and hurt the poor in a nation where more than 800 million people live on less than $2 a day. India’s consumer prices rose 9.87 percent in December, the fastest pace in a basket of 17 Asia-Pacific economies tracked by Bloomberg.

Inflation is a politically sensitive issue in India, where elections have been lost as prices quickened. Prime Minister Manmohan Singh has said his government could have done better on controlling prices while defending policies to buy farm produce at guaranteed prices, boost rural wages, and distribute cheap food.

India’s main opposition Bharatiya Janata Party is likely to win 188 seats in the 545-member lower house in elections due by May, surpassing the party’s previous high of 182 seats in 1999, according to a C-Voter poll for India Today published last week. The ruling Congress party may get as few as 91 seats versus 210 now, dropping to its lowest on record, the poll said.

While demand has remained subdued, inflation pressures are forcing some companies to raise prices. Jindal Steel & Power Ltd. raised its product prices by 1,000 rupees per ton this month, while Indian Oil Corp. increased diesel prices by 0.50 rupee a liter.

‘Breathing Space’

Rajan, a former International Monetary Fund chief economist renowned for his 2005 financial crisis warning, left rates unchanged at the last policy meeting on Dec. 18. He raised the benchmark rate by a quarter-point each in September and October.

Rajan will probably hold the repo rate at 8 percent until December, Australia & New Zealand Banking Group Ltd. economists Devika Mehndiratta and Glenn Maguire wrote in a note after the decision.

“This should give the RBI some breathing space to go into a pause,” they wrote. “But it is unlikely to be enough to allow the central bank to quickly launch into a rate cut cycle.”

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